Base effects are back in the economic conversation as inflation falls from its mid-2022 peaks. So what are base effects and why do they matter?
Simply put, the term base effect refers to the fact that measures of change over time depend on what prior period you are comparing to. OK, well, duh. But it turns out that this can make a big difference in interpreting real-world statistics.
Take inflation. Economists (including me) who report on inflation usually do so on a year-over-year basis, calculating the inflation rate as the amount of price change since the same month a year ago. There is a good reason for doing this, since inflation is very choppy month-to-month, and making comparisons over a longer time frame smoothes out short-term volatility and does not give too much weight to an idiosyncratic monthly jump or drop.
But this can also give a biased views of developments during a time period when inflation is rapidly rising or declining. For example, last fall year-over-year inflation measures were comparing price levels that included the summer run-up to the much lower average prices that prevailed at the end of 2021. That produced high measured estimates of year-over-year inflation that only gradually receded even as monthly changes had decelerated considerably.
You can see this in the graph below that compares year-over-year consumer price inflation to a measure that compares average prices over the most recent three months to those prevailing in the preceding three-month period. Notice how the CPI path flattened after June, 2022 and how the year-over-year inflation measure didn't fully reflect that slowing until very recently. Calculating something like this, or using a three-month moving (trailing) average, allows us to see recent developments that may not be obvious in the year-over-year figures.
In recent months, base effects have tended to pull measured inflation downward. This has been most dramatic for some inflation components that were temporarily expensive during the pandemic and its aftermath. As gasoline and other fuel prices have fallen back from high levels last summer, year-over-year comparisons to those temporarily high prices have resulted in large measured price declines, even though the prices are now pretty stable month-to-month. Same thing for new and used auto prices, which soared during the pandemic when component supplies were curtailed. Food prices may soon do the same thing.
So as we get beyond the period of temporarily super-high prices, the end of favorable base effects is one reason that some economists (including Yours Truly) expect that progress bringing inflation down the rest of the way to the Fed's 2% goal will be harder and take longer than the progress we have seen so far.
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